Tactic Could Compel Greater Fund Disclosure

A former SEC lawyer and the Consumer Federation of America are employing a little-used tactic that could compel disclosures by fund companies unheard of in recent years, according to fund industry lawyers.

Mercer Bullard, president and founder of Fund Democracy LLC of Chevy Chase, Md., and former assistant chief counsel at the SEC's division of investment management, and the federation have asked the SEC to hold a public hearing to explore whether exchange-traded funds should disclose net asset values and premiums or discounts to net asset value at which the fund's shares are trading, throughout the day.

Bullard said he plans to request a number of such hearings when fund companies apply to the SEC for exemptions from provisions of the Investment Company Act. SEC lawyers now negotiate and approve exemption requests in private discussions, although the applications are available to the public.

Fund Democracy intends to use the hearing requests to improve disclosure to fund shareholders about what historically have been obscure industry practices, Bullard said. The threat of a hearing request also may give SEC lawyers more leverage when negotiating with fund company executives over exemptions, Bullard said. Fund Democracy could agree to stop short of having a hearing if it can negotiate changes in proposed exemptions with fund companies, Bullard said.

Fund Democracy made its first hearing request in a letter May 4, asking the SEC to hold a hearing on an exemption application from Barclays Global Investors of San Francisco. Barclays sought the exemption so that it can offer a new series of exchange-traded funds to the public. The Consumer Federation of America of Washington, D.C., also has asked for a hearing on the Barclays' exemption request.

Bullard said exchange-traded funds are a product that will be good for consumers but expressed concern that Barclays' funds will not adequately explain that funds can trade at a discount to net asset value.

SEC officials declined to comment on the hearing request or say when they might rule on it. The SEC has the authority to deny the hearing request.

Exchange-traded funds rarely trade at net asset value, a fact proven by data, according to the Consumer Federation and Fund Democracy.

The consumer groups, therefore, would like the SEC to consider requiring exchange-traded funds to disclose their net asset values and their trading discounts or premiums throughout the day, as well as every quarter for the current and preceding five years, said Bullard. This information is important given the fact that a major selling point of exchange-traded funds is that they can be traded intra-day, said Barbara Roper, director of investor protection, at the Consumer Federation. This benefit is compromised by the fact that exchange-traded funds nearly always trade at a discount or premium to their net asset value, she said.

The consumer groups are also asking the SEC to review the exemption the SEC granted to exchange-traded funds, relieving them of Investment Company Act requirements that they redeem shares at net asset value, Roper said. The SEC made these exemptions because the developers of the original exchange-traded funds argued that they would rarely trade at discounts or premiums to net asset values, Roper said.

"A major reason for their getting an exemption to the Investment Company Act is their claim that they will trade at, or near, net asset value," Roper said. "But, the problem is that when you look at the data of some of these funds, they experience premiums and discounts, sometimes substantial and often prolonged.

"We are especially concerned because we appear to be poised for a major rollout of these investments to retail investors."

At the upcoming SEC hearing, Fund Democracy plans to present data showing a persistent discrepancy between the net asset values and closing prices of exchange-traded funds, Bullard said. He will point to data that Wiesenberger/Thomson Financial collected on the net asset values and closing prices of 30 exchange-traded funds from their inception through April 26. Wiesenberger/Thomson Financial is a division of Thomson Financial, the publisher of this newsletter.

The data shows that 21 exchange-traded funds traded at discounts or premiums of 0.5 percent or more for four consecutive days, Bullard said. Nineteen exchange-traded funds traded at discounts or premiums of one percent or more for four consecutive days, nine exchange-traded funds traded at discounts or premiums of two percent or more for four consecutive days, and 28 of the 30 exchange-traded funds experienced a discount or premium of two percent or more at least once in their lifetime, Bullard said.

Michael Porter, a country analyst with Salomon Smith Barney of New York, said these discounts or premiums were insignificant and usually do not persist.

"Over time, the differences between net asset value and the actual trading price typically is not significant," he said. "On any given day, however, the discount can be significant."

"Barclays' own research does not indicate that there is a discount problem with respect to WEBS," said Tom Taggart, a spokesperson for Barclays Global Investors of San Francisco, which has 47 exchange-traded funds in registration with the SEC.

WEBS have been available for four years, Taggart said. It therefore is "curious" that an objection should be raised about the adequacy of disclosure with respect to WEBS, he said.

"It seems opportunistic," he said.

The exemption process is a crucial one for mutual fund companies. The 60-year-old Investment Company Act does not address a variety of situations that funds now face, according to industry lawyers. Exemptions permit the fund industry to ask the SEC to permit actions about which the law is ambiguous or which may violate the letter but not the spirit of the Investment Company Act, fund industry lawyers said.

For example, funds seek exemptions when they want to invest cash from one fund in another fund within the same complex. The Investment Company Act prohibits these so-called affiliated transactions. The SEC, however, can permit those transactions when fund companies take steps to insure that investors are treated fairly in the arrangements.

"Many exemptions involve innovations that just weren't contemplated when the Investment Company Act was created," said Pamela Wilson, a partner at Hale & Dorr LLP of Boston.